Subprime Lending and House Price Volatility

29 Pages Posted: 22 Dec 2008 Last revised: 16 May 2012

See all articles by Andrey D. Pavlov

Andrey D. Pavlov

Simon Fraser University (SFU) - Finance Area

Susan M. Wachter

University of Pennsylvania - Wharton School, Department of Real Estate ; University of Pennsylvania - Finance Department

Date Written: July 10, 2009

Abstract

This paper establishes a theoretical and empirical link between the use of aggressive mortgage lending instruments, such as interest only, negative amortization or subprime, mortgages, and the underlying house price volatility. Such instruments, which come into existence through innovation or financial deregulation, allow more borrowing than otherwise would occur in previously affordability constrained markets. Within the context of a model with endogenous rent-buy decision, we demonstrate that the supply of aggressive lending instruments temporarily increases the asset prices in the underlying market because agents find it more attractive to own or because their borrowing constraint is relaxed, or both. This result implies that the availability of aggressive mortgage lending instruments magnifies the real estate cycle and the effects of fundamental demand shocks.

We empirically confirm the predictions of the model using recent subprime origination experience. In particular, we find that counties and cities that receive a high concentration of aggressive lending instruments experience larger price increases and subsequent declines than areas with low concentration of such instruments. This result holds in the presence of various controls and instrumental variables.

Keywords: Real Property, real estate, realty, mortgages, housing prices, aggressive lending, interest only mortgages, negative amortization mortgages, leverage, real estate cycle, housing bubble, price peaks, price declines, negative demand shock

JEL Classification: D12, K11, L85

Suggested Citation

Pavlov, Andrey D. and Wachter, Susan M., Subprime Lending and House Price Volatility (July 10, 2009). U of Penn, Inst for Law & Econ Research Paper No. 08-33, Available at SSRN: https://ssrn.com/abstract=1316891 or http://dx.doi.org/10.2139/ssrn.1316891

Andrey D. Pavlov

Simon Fraser University (SFU) - Finance Area ( email )

Burnaby, British Columbia V5A 1S6
Canada
604 291 5835 (Phone)
604 291 4920 (Fax)

Susan M. Wachter (Contact Author)

University of Pennsylvania - Wharton School, Department of Real Estate ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104-6330
United States
215-898-6355 (Phone)

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

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